To The SEC, “Risk” Is A Four Letter Word.

I’ve been attending the 7th Annual Proxy Disclosure Conference sponsored by CompensationStandards.com & TheCorporateCounsel.net.  One of the topics of this very comprehensive program has been the SEC’s requirement that companies disclose their compensation policies and practices as they relate to the registrant’s risk management. Item 402(s) of Regulation S-K.  As I listened to the panelists, it struck me that the SEC’s disclosure requirement embodies a very one-sided view of risk that focuses exclusively on the probability of negative returns rather than all possible outcomes:

The purpose of this paragraph(s) is to provide investors material information concerning how the registrant compensates and incentivizes its employees that may create risks that are reasonably likely to have a material adverse effect on the registrant.

There are several problems with this approach.

First, the concept of “reasonably likely” is incapable of rational definition.  The likelihood that an event will occur (i.e., its probability) is simply a measure of the expectation that it will occur.  A probability is neither reasonable nor unreasonable, it simply is.  It is complete nonsense to say that an event is reasonably likely.

Second, risk in financial terms usually refers to the variability of results around an expected return.  These returns can be either positive or negative.  Assume, for example that a company is considering a possible compensation strategy with the following outcomes:

Here, the expected return is $400,000 ($100,000 + $400,000 – $100,000).

Rather than looking at all possible outcomes, Item 402(s) focuses exclusively on a single possible event – a material adverse effect.  The SEC then requires an assessment of whether the chance of that negative outcome is “reasonably likely”.